August 22, 2011

Shaky situation: Unstable financial times may mean short-term rate hikes down the road

When Standard and Poor's recently downgraded the U.S. credit rating from AAA to AA+, the financial markets immediately started to fluctuate, and fears began to rise about the effect the downgrade would have on other sectors of the economy.

A financial expert at Kansas State University says this uncertainty can be expected in today's unprecedented times.

"It's been a long time since we've had this uncertainty," said John Graham, professor of finance at K-State. "Market participants seem to be able to deal with good or bad news, but they hate uncertainty. It leads to fear and to the emotional or the sometimes irrational investor decisions like we've seen the last few weeks with stocks going way up and way down on almost a daily basis."

In theory, credit ratings for a nation work the same way as they do for any other organization that issues debt, he said, by assessing an organization's ability to repay principle and interest in a timely manner. The drop in the U.S. rating has caused many investors to fear that interest rates across the U.S. could skyrocket, but Graham said this might be an overreaction.

"There's been a lot of hyperbole and overstatement about the debt downgrade, but it's my opinion that it has been grossly overblown," he said. "They're trying to send a message to public policymakers that they need to address the issue of public debt and continuing deficits. It's an effort to get their attention to address these issues in a credible manner."

Normally the investment world could expect interest rates to increase with a downgrade like this, Graham said. But because so many interrelated parts are moving at the same time -- like economic trouble in Europe -- the U.S., as the world's largest economy, is still viewed as a place to find relative stability.

Immediately after the debt downgrade was announced, investors saw worsening conditions in Europe, Graham said, and became nervous about the economy and the financial markets. This caused individuals to continue seeing the U.S. Treasury as a safe haven, and interest rates went down significantly.

"It sounds counterintuitive, but that's the way the market reacted to it," he said.

However, Graham acknowledged that the heavy Federal Reserve and government involvement in the economy and Federal Treasury security markets makes these uncharted waters, and it can be difficult to determine what influence the downgrade will have on other rates, like for those on student and auto loans. But since market participants typically determine rates, Graham said these types of interest rates might not be affected.

"If investors get nervous, rates go up, and if they get more confident about the treasury debt, rates will go down," he said. "It's purely supply and demand."

Graham said he believes student, auto and other types of loan interest rates may be relatively safe for the time being due to the Federal Reserve's recent announcement that it planned to keep short-term rates low for at least two more years.

If that happens, he said, the typical expectation would be that other types of rates would not rise rapidly either.

"They might tick up, but they won't spike up," he said.

The bigger concern for those looking to apply for a student loan in the future is whether the money will actually be available. Graham said the primary way that student loan rates go up, other than government intervention, is if demand exceeds the supply of money for these loans.

If lenders back off of making those loans because they lack capital or there is too much perceived risk, Graham said it is possible rates could increase. However, in the short term, the market uncertainty and weak economy should keep increases minimal, he said. The danger is if inflation continues to accelerate and federal budget problems continue for an extended period.

"Part of the money for student loans comes from financial markets and part from federal government financing," Graham said. "If budget problems lead to less money, it could also lead to higher rates because those who can get money are willing to pay more. It also might lead to less availability of money."

Rates may not go up, he said, but fewer loan-seekers may be able to get their hands on the money that is available.

"I don't see anything in the short run, but it might be more of what comes up from the great deficit debate," he said.